Join Jim Stice for an in-depth discussion in this video Return on equity, part of Finance for Non-Financial Managers.
- Return on equity is a general overall measure of how well a firm is doing. The DuPont Framework breaks Return on Equity down into three parts: Profitability, Efficiency, and Leverage. Let's use an example to illustrate. You can see here that we have Uncertain's Balance sheet, and their income statement. What can we conclude by looking at this? For starters, we can see that they had Total assets of $14,500, Sales of $20,000, and Income of $700.
Is that good? Is that bad? It's hard to tell, so let's compare them with Benchmark company. What can we conclude by looking at Benchmark and Uncertain side by side? Well, the first thing we notice is Benchmark is bigger. And if we do a little mental math, we can conclude, well, it looks like their net income's higher relative to their sales. But just a raw comparison of Benchmark's financial statements with Uncertain's financial statements that's tough to do. There has got to be a way to compare these two different companies of different sizes.
So, we're going to begin with our first financial ratio. My favorite, and most people's favorite, Return on Equity. Return on Equity is computed by dividing net Income by stockholders equity. It's a measure of the amount of profit earned per dollar of investment, and it's affectionately known as ROE. Return on Equity, ROE. Now, let's compare Uncertain and Benchmark's ROE. As you can see, the return on equity for Uncertain was 9.3%. Compare that with Benchmark at 20.3%.
What does that 9.3% mean? Well, it means for every $100 that's been invested by Uncertain's owners, those owners earned a return of $9.30 in the most recent year. Is that good? Is that bad? Well, it's certainly not as good as Benchmark. But 9.3% by itself, what does that tell us? Well, in general with respect to Return on Equity, or ROE, greater than 20% is very good. Less than 10%, not so good.
And typically, companies are between 10 and 20%. Between 10 and 20% is normal. So, in the case of Uncertain that 9.3%, well, that's not good. As an example, let's take a look at some companies with which we're all familiar. It's no surprise that Apple and Microsoft have very good Return on Equities. No surprise at all. In the case of Gap, a retail clothing chain, their Return on Equity in 2014 was a stunning 42.3%.
Above both Apple and Microsoft. Wal-Mart at 19% finds itself in the normal range. And you can see for both Ford and General Motors that they are at 12.9% and 11.1%, respectively at the lower end of the normal range. When it comes to Return on Equity it is a general overall measure of a company's performance for a given period of time. And it is the foundation for one of the most amazing creations in accounting history, The DuPont Framework.
- Interpret financial reports and make decisions based on available data
- Manage inventory and receivables
- Create an accurate budget
- Cost a product or service
- Analyze customers
- Understand your income taxes
- Communicate your contribution to the bottom line